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And how they may affect your finances
There are many taxes that we pay in our daily lives. They affect our paychecks, the prices of products we buy, the services we use, our homes, our cars and more.
And while sometimes the lines blur between different types of taxes, having an idea what you’re paying, when you have to pay it, and how much you’re paying can make it a lot easier to manage your personal finances.
In this article:
While there are many individual taxes, following are the three main types of taxation. They describe ways that a tax applies to the person or group being taxed.
This is a type of taxation where as you have more income that is subject to tax, you pay higher average rates. This mostly relates to income taxes. The term “progressive” comes from the fact that as taxable income increases, the tax rate gets progressively higher.
The federal income tax brackets are an example of progressive taxation. The federal government uses marginal tax rates, which tax income within a certain range at one rate and income in a higher range at a higher rate.
The opposite of a progessive tax is a regressive tax. This is a method of taxation where as you have more that is subject to tax, your average tax rate is lower. One example of a regressive tax is the Social Security tax, a type of payroll tax (more on that later).
All taxpayers need to pay the Social Security tax. For 2019, income up to $132,900 is subject to the tax. The higher your income goes above that limit, the lower the average rate that you pay.
A proportional tax is one where the amount you pay is proportional to how much you have. You will also hear people refer to this as a flat tax. For example, imagine you live in a state with a flat income tax of 5%. Each taxpayer will pay 5% of his or her taxable income. Since everyone is paying a proportional amount of their income, this is a proportional tax.
The three types of taxes above describe systems of taxation. The following are examples of the taxes you may actually pay in your daily life.
Income tax is a tax on your income, wages and earnings. The federal government uses a progressive tax with seven marginal tax rates. It collects income tax over the course of the year. For most people, income tax comes out of your paycheck. If you are self-employed or a freelancer, you will probably need to make estimated tax payments each quarter.
Ideally, you would pay the exact amount that you need to, but since many people overpay slightly, they receive a tax refund each year.
Like the federal government, most states also have an income tax. Only seven states do not have an income tax:
New Hampshire and Tennessee do not tax most regular income but do tax income from interest and dividends. (Note that Tennessee’s tax on investment income will expire in 2022.)
Nine states have a flat tax rate:
The remaining states all use marginal tax brackets, though the number of brackets and the income ranges differ. For example, Alabama has tax rates of 2%, 4% and 5% depending on your income.
Some cities, counties and local governments also collect income taxes. In Missouri, Kansas City and St. Louis collect an income tax. In Maryland, each county collects its own income tax. In Oregon, cities in the Portland area pay an income tax to support public transit.
These are taxes that employers remove from your paycheck and send to the appropriate government agency. If you’re a freelancer or self-employed, you will need to pay these on a quarterly basis via estimated taxes.
In addition to income taxes, there are federal taxes that fund Social Security and Medicare. These together are the FICA (Federal Insurance Contributions Act) taxes. Taxpayers need to pay 6.2% of their income to Social Security and 1.45% to Medicare. Your employer also contributes an equal amount of FICA tax for you.
There is an additional Medicare surtax of 0.9% for single filers who earn more than $200,000 and joint filers who earn more than $250,000. This tax, called the Additional Medicare Tax, applies only to income above those thresholds.
If you’re self-employed, you have to pay the same income and payroll taxes that others pay. But instead of paying the FICA tax, you have to pay self-employment tax. That’s a tax equal to 15.3% of your income - 12.4% for Social Security and 2.9% for Medicare.
The good news is that you can deduct 50% of your self-employment taxes when you file your annual income taxes.
When you sell assets, you may have to pay capital gains tax on your net gains. Common assets include investments and real estate. You also have to pay tax when you sell collectible or valuable items, such as jewelry or a collection of rare stamps.
The federal capital gains rate you pay depends largely on how long you owned the asset. You pay the short-term capital gains rates if you held assets for one year or less. These rates are the same as regular income tax rates.
You pay the long-term capital gains rates, which are lower than the regular tax rates, if you held assets for more than one year. Note that states that collect income tax also collect capital gains taxes.
Estate tax applies to the money and assets that you pass on after your death. This includes cash, investments, real estate and other valuables. The federal government collects an estate tax, as do 12 states and the District of Columbia.
Your estate pays the tax but how much you pay, if you have to pay anything at all, depends on the value of the estate. Only estates valued above a certain threshold are subject to tax. This threshold is also known as the exemption or exclusion amount.
The federal exemption for 2019 is $11.4 million. This value will increase slightly each year to account for inflation. About a dozen states have their own estate tax and exemption amounts vary by state. Some use the same exemption as the federal government. Massachusetts, has one of the lowest exemptions at $1 million.
Most of your assets factor into your estate’s value, but note that the death benefit from a life insurance policy does not.
Similar to an estate tax, inheritance taxes apply to what’s passed on after someone dies. However, the tax doesn’t come out of the estate before being passed on. Instead, the person inheriting the money or assets pays the tax depending on how much they have inherited.
There is no federal inheritance tax and just six states collect an inheritance tax. (Maryland collects both an estate and inheritance tax.) The tax rate depends on how much you inherit and your relationship to the deceased.
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An ad valorem tax is based directly on the value of a good, service or property. One of the most common ad valorem taxes in the U.S. is property tax.
When you buy a home, in addition to your mortgage and homeowners insurance, you will have to pay property taxes. This is an ad valorem tax based on the value of your property. City or county governments usually collect property taxes. Some areas also levy taxes by school district or according to other local districts.
How much you pay depends on where you live. Not all places collect property taxes based on the entire value of your home. For example, you may live in an area that collects tax based on just 40% of the value of your home.
How your locality determines property value will also differ from place to place.
A consumption tax applies when you purchase certain goods and services. These are often indirect taxes because even though the government is collecting the tax from a retailer, the person who buys the good is the one who pays the tax. (A direct tax applies not to goods or transactions but to someone’s income, profit or assets. Federal income tax and property taxes are direct taxes.)
Two common types of consumption taxes are sales tax and value-added tax.
Sales tax applies to goods and services you buy. You pay them at the point of sale. There is no sales tax at the federal level, but states, cities and local districts may all have their own taxes.
Not all places collect sales tax and different areas charge different rates, based on what you’re buying. For example, a state may collect a 2% tax on groceries but a 4% tax on all other goods.
Sales tax is also a type of ad valorem tax; the amount you pay depends directly on the value of what you’re buying.
A value-added tax (VAT) applies to goods you purchase. It’s similar to a sales tax in that sense, but it’s different because a VAT isn’t just applied to the final sale price of a product. It applies at each stage of the production process, based on the value that has been added to the product.
Since the product is taxed throughout production, the price you see in a store already includes the VAT. This is different from sales tax, which you pay in addition to a retailer’s price.
The U.S. does not have a VAT but it is common in other countries and especially in Europe. Like sales tax, this is also an ad valorem tax.
An excise tax applies to particular goods, services and activities. This is different from a sales tax because it applies only to specific transactions.
Excise taxes are usually included in the price you see for a product. Some excise taxes are ad valorem: When you buy an airline ticket, there is a 7.5% excise tax included in the ticket price.
Other excise taxes are the same no matter the value of the product. For example, the federal government levies an excise tax of 18.4 cents on each gallon of regular gasoline. Whether a specific company was planning to sell you gasoline for $2 or $3 per gallon, the excise tax is still 18.4 cents per gallon. Each state also has its own excise tax for gasoline.
Excise taxes are a very popular way for federal and state governments to raise revenue. According to the Urban-Brookings Tax Policy Center, federal excise tax revenue in 2017 was more than $83 billion.
Common excise taxes you’ll see at either the federal or state level are on alcohol, tobacco, fuel, airfare and telecommunications services.
There are also health-related taxes, like the Affordable Care Act’s individual mandate, and environmental taxes on pollution or gas emissions.
While a bit outdated, you may also see the term “sin tax.” This refers to taxes on products or activities that are considered harmful to individuals or to society as a whole. The excise taxes on alcohol and tobacco are considered sin taxes, as are those on sugary drinks, gambling, and indoor tanning.
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A surtax is a tax on something that is already taxed. Surtaxes usually apply only to individuals who are above a certain threshold. For example, all taxpayers contribute to Medicare through a Medicare tax. Single-filers who earn more than $200,000 also have to pay a surtax of 0.9% (the Additional Medicare Tax) on all wages that exceed $200,000.
With individual income taxes, you generally pay tax based on the total amount you made (revenue). Corporate taxes typically apply to a company’s profit, which is its revenue minus expenses.
Corporate tax rates are also different from individual tax rates. Instead of the seven marginal rates, the federal corporate tax rate is a flat 21%. Many states also have rates that are different from their regular income tax rates.
For example, Maine’s personal income tax rates start at 5.8% and go up to 7.15% across three income brackets. The corporate tax rates range from 3.5% up to 8.93% across four brackets.
A tariff is a tax on goods that cross national borders. The country importing a good collects the tariff. In many cases, tariffs are a way for a government to bolster local businesses or to level the playing field with foreign competition.
For a real-life example, here’s a look at tariffs the Trump administration imposed on Chinese goods.
Policygenius’ editorial content is not written by a certified financial planner or advisor. It’s intended for informational purposes only and should not be considered legal, financial, or investment advice. Consult a professional to learn what financial products are right for you.
This post contains references to products or services from one or more of Policygenius' advertisers or partners. While these codes earn us a small fee at no additional cost to you, they do not influence editorial content and we only refer products we love.
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